MAULDIN: Europe Is Now Creating Big Unintended Consequences That Will Carry Disastrous Outcomes

"Illusions commend themselves to us because they save us pain
and allow us to enjoy pleasure instead. We must therefore
accept it without complaint when they sometimes collide with a
bit of reality against which they are dashed to pieces."

For every government law hurriedly passed in response to a
current or recent crisis, there will be two or more unintended
consequences, which will have equal or greater negative effects
then the problem it was designed to fix. A corollary is that
unelected institutions are at least as bad and possibly worse
than elected governments. A further corollary is that laws
passed to appease a particular group, whether voters or a
particular industry, will have at least three unintended
consequences, most of which will eventually have the opposite
effect than the intended outcomes and transfer costs to
innocent bystanders.

This week we wonder about the consequences of the
European Central Bank (ECB) issuing over €1 trillion in
short-term loans to try and postpone a banking credit crisis
and lower sovereign debt costs for certain peripheral countries
in Europe. What if, instead of holding the European Monetary
Union (EMU or Eurozone) together, that actually makes a breakup
more likely? That would certainly fall under the rubric of
unintended consequences, and be worth our time to contemplate
in this week's letter.

But first, and quickly, we are now ready to take reservations
for the 9th Annual Strategic Investment Conference,
May 2-4, which this year will be in Carlsbad, California for
the first time, at a venue that will allow us to take a few
more attendees but still keep that intimate feeling. I host the
conference, along with my partner Jon Sundt and his team at
Altegris Investments.

Each year I wonder how we could make the conference any better,
but I think we have done it. I must say that I do not think any
conference anywhere has the quality speaking line-up that we
do. It is the finest collection of top-notch raconteurs posing
as economists assembled anywhere. Each speaker is a headliner
in his own right, wherever they go. We have nothing but the
best each year.

Look at this line-up: Dr. Woody Brock, Mohamed El-Erian,
Marc
Faber, Niall
Ferguson, Jeff
Gundlach, David Harding, Dr. Lacy Hunt, Paul McCulley,
David McWilliams (from Ireland), David
Rosenberg, Jon Sundt, and your humble analyst. Plus the
surprise guests. Seriously, where else can you find all that
talent under one roof? I design the conference each year to be
the one that I would want to attend. And Sundt and team run as
smooth and enjoyable a conference as you will find anywhere.

Signing up will also give you access to exclusive papers and
webinars. For example, next week I'll be interviewing
Winton Capital Management. For regulatory reasons, you will
need to speak with Altegris to verify your accredited-investor
status, prior to being allowed to attend. You can learn more
and register by going to http://meetings.StrategicInvestmentConference.

I should note that the best feature of the conference is the
attendees themselves. You will make new friends and meet old
ones. And the speakers are very accessible. The price goes up
considerably on March 15, so register early. We always sell
out, and I get calls asking to get in at the last minute, and
have no way to help. Don't procrastinate. Register now. We are
way ahead of last year on the pace of registrations. Again, it
will sell out. Do it now.

Unintended Consequences

The ECB injected (created? printed?) €529.5 billion for an
annual cost of 1%, more than the €489 billion they issued just
last December. This was called a long-term refinancing
operation, or LTRO. The total now is over €1 trillion euros
(around $1.3 trillion), which can only make Ben
Bernanke jealous. That money was technically issued to the
various national central banks, who in turn lent it to their
various commercial banks for almost any collateral that still
had a pulse. Which banks in turn used it to shore up their
balance sheets, and any spare change was used to buy more
sovereign debt of their countries, thus financing their own
government's deficits. And making a nice juicy spread for the
next three years, which can help repair that balance sheet.

I can't find a chart I have permission to use and don't feel
like spending three hours to make one just to show that the ECB
has simply exploded in the last 6 months, swelling almost four
times in that period, on a time-adjusted basis. Just imagine a
slowly rising line that viciously turns north beginning July of
last year. As in a "J" curve.

Did we see a rise in loans to commercial establishments? Easy
money for all? Hardly.

The markets were quite happy that a credit crisis has once
again been put off. So were the various governments. Did we see
a rise in loans to commercial establishments? Easy money for
all? Hardly. So what did the banks buy with their new money?
(Besides the chance to deposit it back at the ECB?) They bought
short-term government bonds, which more or less matched the
terms of the money they had borrowed.

Which collapsed shorter-term bond yields. In November, Spanish
one-year bonds paid about 5% over similar German bonds. Today
it is less than 1% more. Still a nice total spread over 1%.
Three-year bonds have dropped from around a 5% spread over the
corresponding German bonds to slightly under 3%. Italian debt
has dropped from a spread (over German yields) of 6% to 1% for
one-year bonds and from over 7% to under 4% for three-year
bonds. Nine and ten-year bonds are roughly the same for both
countries as three months ago.

Sufficient Unto the Day

So what does a country with deficits and growing debt do? It
sells lower-current-cost short-term bonds to help its current
deficit (more on that later), rather than take on longer-term
debt. It can also buy back more expensive longer-term debt sold
last year for much lower short-term rates today.

But that means there is more roll-over risk in the very near
future, as you have to borrow to replace those bonds when they
mature; but why worry about that today? As my Dad was wont to
say when he wanted to ignore the problems cropping up in his
future, "Sufficient unto the day is the evil thereof."

I saw a table created by those clever people at Bridgewater.
They analyzed the nature of the capital of the banks of various
European countries. Not much has changed in the last few years,
except that foreign capital is still fleeing and that capital
is being replaced (almost euro for euro) by ECB debt. Let us
make no mistake, without ECB largesse, European banks would
either have to sell equity at fire-sale prices or their
governments would have to nationalize them. Otherwise they
would be insolvent. And that would in all likelihood mean a
credit crisis worse than 2008, as hard as that is to imagine.

And while many applaud Mario Draghi's actions, as they feel he
has averted a crisis with his initiation of the LTRO, there are
others who are not pleased. This note from yesterday's
Financial Times:

"The head of Germany's Bundesbank has launched a powerful
attack on Mario Draghi, president of the European Central Bank,
in a sign of mounting concern in Europe's biggest economy at
measures being taken to try to contain the eurozone financial
crisis.

"Jens Weidmann's warning of increasing risk stemming from some
ECB policies highlights fears of potential costs for Germany
from its role as the eurozone's biggest creditor nation and may
spark fresh doubts about the eurozone's ability to deal with
the long-running banking and sovereign debt crisis.

Peter
Sands, the head of Standard
Chartered (a British commercial bank), warns that the new
money runs the risk of "laying the seeds for the next crisis."
He wonders what happens in three years' time when all that debt
needs to be refinanced. That seems a reasonable question, as
finding a spare €1 trillion will not be a lot easier in three
years.

The concern is that the ECB is now committed to more than just
€1 trillion. As noted above, ECB financing, which amounts to
almost 8% of peripheral countries' bank financing, has offset
foreign (to the home country) debt that is leaving. Since that
exodus is accelerating, the word fleeing may be more
appropriate. And foreign investors (mostly banks, as I
understand it) have another 14% of funding in peripheral banks.

The concern is that the ECB may have to come up with even
larger sums to offset the losses as foreign assets flee.
(Foreign in the sense that they are not from in-country
sources. As an example, Italian banks have about 6.5% of ECB
funding and 12% of foreign – non-Italian – funding.)

There is really no way to know how much will be needed to
forestall a further crisis. The ECB has so far signaled it is
willing to step up, and the markets seem to see no reason it
won't continue to do so.

But therein lies the unintended consequence. In an effort to
keep the eurozone from breaking up in the midst of a credit
crisis, they may have made it easier for it to break up in the
future. To understand why, let's revisit Greece a few years
ago.

Was it only three years ago that the market was willing to lend
Greece all the money it wanted at rates not far above those of
Germany? And then it seemed like, all of a sudden, in the blink
of an eye, Greece could no longer sell debt at interest rates
that allowed it to credibly have a hope of repaying the debt.

And Europe had to step in and bail them out. But let's be
certain of one thing. As I was writing back then, the ONLY
reason that Germany, France, et al., were willing to continue
to lend Greece money was that their banks had bought so much
Greek debt that if they had to write it off all at once it
would cost the various governments hundreds of billions. The
financing package of €130 million that Greece will get? €100
billion goes right back to private bondholders, mostly banks
and institutions (like insurance and pension funds). Just to
create the fig leaf that there is no default. So Greek debt
actually goes up, even though there is a haircut on current
debt. (More on that below.)

If the only banks that held Greek debt had been Greek banks,
then Europe would simply have let Greece go under, with its
banks. Maybe some token help, but nothing like the amounts that
have been funded. Greece would have had no choice but to leave
the eurozone and return to the drachma.

I wrote at the time that we would know when German banks had
essentially sold their Greek debt, written it down, or were
otherwise able to handle a default, because Merkel would no
longer be willing to fund Greece. That point was essentially
reached a few months ago. Now Europe keeps demanding ever more
austerity from Greece, and every time Greece agrees they move
the line and ask for more. Greece is now going to have to
demonstrate it is willing to cut spending and raise taxes, no
matter what.

Greece's economy will experience deflation this year as GDP
falls 4.4%, the nation's fifth straight year of recession,
according to the European Commission. Greece's economy
contracted 6.8% last year and 3.5% in 2010.

As recently as November, the commission forecast the Greek
economy would contract just 2.8% this year. But just two weeks
ago that estimate was blown away. Fourth-quarter data showed
Greece had contracted by almost 7% in 2011. But they had just
agreed to massive austerity cuts for the next ten years,
totaling as much as their current annual GDP. In an economy
where government spending is 40% of GDP. Such cuts will make it
even more unlikely they can meet their targets.

Europe will then demand even more cuts when the targets are not
reached (or increases in taxes on what's left of the private
sector). Everyone realizes the party is over, but no one wants
to be the first to leave. It simply will not do for the
eurozone to expel a member. The precedent is dangerous. So they
make staying in the eurozone so onerous that leaving eventually
becomes the best choice (more on that later). "We
didn't tell force you to leave; it was your own choice."

So what is happening now is that European banks are slowly
shedding their foreign sovereign debt and buying the sovereign
debt of their own countries. More Italian debt is coming home
to Italy, Spanish debt to Spain, and so on. Given ECB funding,
this process will go on for several years.

And at some point, if Spain or Italy decided to partially
default, then European banks will be able to absorb the losses.
If one of the peripheral countries does not get its budget in
order, then it too will have to face the music of austerity and
rolling recessions, just as Greece is, in order to get funding
from Europe.

If, as an example, Europe decides to no longer fund Spanish
debt (at the cost of German and other taxpayers) without
draconian austerities, what then? Since Spanish debt will
mostly be in the Spanish system (banks, insurance, pensions,
etc.), if Spain decides to leave the eurozone it will be much
easier on the larger European system.

I think the very fact of allowing (encouraging?) the various
countries to bring the debt home to internal banks and
institutions is in fact increasing the likelihood of exit from
the eurozone, when a future crisis occurs . It's all well and
good to talk solidarity, but continuing to fund the peripheral
nations at the cost of other taxpayers, with the accompanying
damage to the euro, will soon wear thin on voters in those
other countries.

Far-fetched? Aren't Spain and Italy getting their act together?
Kiron Sarkar makes the following points, with which I agree, so
let's jump to him (courtesy of The Big Picture):

"Spain unilaterally set its 2012 budget deficit at 5.8% of GDP,
much higher than the 4.4% previously agreed with the EU. The
budget deficit came in at 8.5% last year, once again higher
than the target of 6.0%. A ‘discussion' between Spain and the
EU is inevitable, especially as (to date) the EU has insisted
that Spain sticks [sic] its prior commitment. Quite an
interesting development, particularly as it has come on the
same day that 25 out of 27 EU countries (excluding the UK and
the Czech Republic) signed up to the ‘fiscal compact' which,
once approved by each country's national Parliament (Ireland
will need a referendum), will introduce the German inspired
‘debt brake' into their constitutions – basically commits the
25 EU countries to reduce borrowings and, indeed, balance their
budget deficits.

"The EU has a tough task. If it offers concessions to Spain,
expect Portugal, Ireland, etc., etc. to submit their own
‘requests.' However, I just can't see how Spain can meet its
prior commitment. Officially, GDP is forecast to be -1.0% to
-1.7% this year, though in reality the actual outcome will be
closer to (indeed may exceed) the more pessimistic forecasts.

"Whilst Spain is facing increasing pressures, Italy announced
today that its 2011 budget deficit fell to -3.9% (-4.6% in
2010), better than the -4.0% forecast. 2011 GDP came is a
marginally higher at +0.4%, (+0.3% expected). Whilst Italy
entered into recession in the last Q of 2011 and its economy is
expected to contract this year, Italy has pledged to balance
its budget deficit by 2013.

"As I keep banging on, Italy is in far better shape than Spain,
in spite of its higher headline debt to GDP. Spanish and
Italian bond spreads continue to converge – I remain of the
view that Italian bond yields will decline below equivalent
Spanish bonds."

With that in mind, let's change the focus a bit.

What Should Greece Do?

This is a hard question. If Greece borrowed money from me, I
would want them to pay. But if I am Greek the situation looks
different. Let me take a cold-blooded look at what will offer
the best long-term economic outcome for Greece, laying aside
all the moral arguments about paying one's debts, etc.

The simple arithmetic is that Greece cannot afford to pay its
debts. They are getting ready to give debtors close to a 70%
haircut, if you figure in the time cost of money. There is no
way in Hades, to borrow a Greek term, that they can get back to
120% of debt-to-GDP by 2020, given the massive austerity they
have agreed to and which is just the beginning. (Is 120% now
the new sustainable level because that is where Italy and
Belgium are?)

Forcing debtors to take such a loss is not going to entice
future lenders. Greece is effectively shut out of the bond
market for a very long time. Their only source of borrowed
money is the EU, and that debt is now costing the future of the
country for at least a generation.

Most Greeks who are able send their children abroad to study.
Given that the unemployment rate for people under age 25 in
Greece is nearly 50 percent, it appears few young people are
returning from abroad. In September 2011, organizers of a
government-sponsored program on emigration to Australia, a
program that reportedly attracted only 42 people in 2010, were
overwhelmed when more than 12,000 people signed up to attend.
(Source: Stratfor)

What is the point of paying back part of the bonds if you don't
get access to future bonds? The current program offers no hope,
and the people of Greece know that.

Greece should declare an "emergency," along with a bank
holiday, and leave the eurozone and return to the drachma. Keep
as much hard currency and reserves as you can, so you can buy
needed medical supplies and energy until things turn around.

Don't pay one dime of debt to anyone for at least a few months,
if not years. Default on every penny. Let the market set a
value on the future currency, and only then offer to give two
drachmas of debt repayment for the value of one drachma in hard
euros in new debt. If you get no euros, then give no drachmas.
But be very frugal about making that offer. Run up as little
debt as possible in the beginning.

Play the political game, of course. Maybe even promise
participation in a better future, when that happens.

Meanwhile, get your budget house in order. Figure out how to
eventually run small surpluses, which will be easier if you
don't have to pay for that old debt. Fix future growth of
government spending to some percentage of GDP growth.
Amazingly, you will soon – in just a few years – be seen as a
worthy credit and be allowed back into the bond market. Ask
Iceland or even Argentina (if ever there was a country that
should be shut out of the world bond market, it is Argentina.
They have made a national sport of defaulting on debt. Go
figure.)

Right now tourism is 15% of your GDP. Make it 25%. Divert
resources to make it happen. Make your country the best
vacation value in Europe. Get your people, who are naturally
hospitable, to get behind the drive for more tourism. Greet
each traveler like someone bringing you gold, because that is
what they are doing. That hard currency is what will buy you
the resources you need (like food, energy, and medicine).

Note: you are not leaving the European Union, just the euro.
There are lots of members of the EU that have their own
currencies. You will just be another such country.

But since there will be a black market in euros if you try to
keep a closed currency, at some point not too long after
converting everything in the banking and financial system to
drachmas, just go ahead and let people use their euros. Let
businesses post two prices, but all government transactions
will be in drachmas. Your citizens and businesses must pay
their taxes in drachmas. If they take euros, they will need to
find the drachmas to pay the VAT or other taxes.

Don't let the central bank go crazy printing money. That will
just cause inflation and drop the value of the drachma further,
postponing a recovery.

If a business wants to open a factory, then make it happen.
Encourage all the foreign direct investment you can. Give them
a tax holiday. Look at Ireland and match their tax rates. No
government red tape to open a business, just bring your money
and jobs. If some of your citizens "magically" find some euros
that were in offshore bank accounts and want to bring them back
to invest, let them. Declare a tax holiday on all money that
shows up. Let them bring their euros back for the market price
of the drachma until things stabilize.

Drop your tax rates to the lowest in Europe and then enforce
them. The lower you make them, the more money you will raise in
taxes. Look at some of the old Warsaw Pact countries.
Selectively sell your government-owned businesses to get the
currency you need for infrastructure (roads and such) and to
remove the annual losses they have from your books. Or simply
give most (and in some cases all) of the assets to the
employees and unions, for businesses like your railroads.

There are local contingencies and characteristics I am not
close to being aware of, I am sure. But structure everything
that you can for the future, which will arrive faster than you
think. There is a huge Greek diaspora. If they see opportunity,
they will invest, if not come back. Make sure they see it.

It will be tough for the first year or two. But then you can
grow your way out of the crisis, at first slowly and then more
rapidly. There are myriad examples of countries that have done
similar things without your natural advantages.

But staying in the euro and trying to pay that debt will just
put chains on your children and elderly. You have been in
recession for close to five years. Staying in the euro will
mean at least another ten. Facing such a bleak future, the
young and entrepreneurial will leave, which is what you cannot
afford. They are your most precious asset. Without them there
is no growth and no future.

Is leaving the euro and returning to the drachma a good choice?
No, it will be a disaster. But I think it will be a lesser
disaster than staying.

And Then There Is Ireland

What do the Greeks get by staying? My friend the Irish
provocateur David McWilliams writes last week about how Ireland
should view the Greek deal:

"For Ireland, this [the Greek deal] means that we will get a
deal on bank debt most definitely. It might take time because
the last thing the ECB wants is a queue of ‘me too' demands
from Ireland and Portugal. But it is clear that our hand has
been strengthened, if we decide to play it.

"But just in case you think this is a victory for the citizen,
let's examine in a bit more detail how it works. There will be
no default. Greece will be given a €130bn loan. With that loan
it will pay out €100bn to bondholders, who will have seen their
bonds fall 53pc in value. After the penal interest Greece has
paid on these bonds already, we still see an insolvent country
paying bondholders 50pc of face value when they should be
getting nothing.

"So Greece gets €100bn written off, but borrows €130bn in order
to achieve this, so it is still borrowing more making its
overall debt not better but worse in absolute terms.

"Now it needs to grow to bring these figures down and that is
going to be impossible. So we are going to be back to square
one in a few years except for one crucial thing.

"After all this is done, private creditors to Greece will have
been paid by European public money stumped up by the taxpayers
of other European countries. The banks have been bailed out
again. Without help they would have got nothing. They now get
50pc of their worthless holdings and the subsidy comes from the
taxpayer."

David is going to be at the Strategic Investment Conference, as
I mentioned at the beginning of the letter. I am going to give
him the podium and then put him on a panel with Marc Faber (a
[Swiss] Austrian economist) and maybe even the Scot Niall
Ferguson, and throw some raw meat up on the stage and see what
happens. It will be highly instructive and good fun as well.

You can see what McWilliams is calling "Punk Economics" at
www.davidmcwilliams.ie. It is a short video clip
but fascinating. He represents a growing populist strain in
Europe. And he does so with Irish verve and humor. You've got
to love it.

New York, Orlando, Sweden,
and Paris

I leave for New York for two days tomorrow. I will be on Tom
Keene's show on Bloomberg
Radio at 9:30 am or so. That is always fun. And meetings and a
fun dinner with friends. Then a quick trip to Orlando the next
weekend for a speech. And then I leave for Stockholm to give a
talk, spend a day or two simply being tourist, write my letter
on the way to Paris, and then play tourist some more for the
weekend, along with meeting a few managers that my partner Jon
Sundt of Altegris Investments will introduce to me. Then on
Monday we will both attend the GIC conference at the Banque de
France, with our friend Paul McCulley. The title of the
conference is Re-Examining Central Bank Orthodoxy for
Unorthodox Times: Inaugural Meeting of The Global Society of
Fellows (this is also a link, if you want more
information). There are a few spots still left. It will be a
most fascinating time to talk about central banking in Europe.

My daughter Melissa was in the audience, as she was in the area
attending a writer's seminar and stayed over to listen to Dad,
which she has not often been able to do. She had to leave as I
was doing Q&A, and I said goodbye from the podium.

She turned around, grabbed the microphone from a gentleman
standing there, and said, "Since you mentioned me, is it
alright if I ask a question?"

It had been a rather intense speech, even if I did get a few
laughs here and there, so I was curious as to what had piqued
her interest. Let me say that she does not share Dad's
political leanings. (I don't know where I went wrong.) She is
also not shy, so I was bracing for a tough question. The
audience was on the edge of their seats, waiting to hear what
she would ask, as well. And then it came:

"Yes," I said, even as I knew I was being set up. I had
mentioned the new iPad in the context of telling them to get
one so they could get my book. And I do love my iPad. And I
will scramble to get one as soon as the new ones come out. They
are way cool.

"Ok then, can I have your old one?"

What can you say? She knows all the brothers and sisters will
soon be asking the same question. But you are on stage and she
has asked so sweetly. How can you refuse? You just smile and
say yes. She has great timing.

(Note to Apple
marketing management: You should make sure I can buy one before
I leave for Europe. I will show it off everywhere. I am willing
to pay for the privilege of advertising your product. I just
want one as soon as possible. Please.)

Have a great week. Find a few friends and spend some time with
them. It makes it all worthwhile.